Active vs. Passive Investing: A Complete Guide

Jan 12, 2022

Active vs. Passive Investing: A Complete Guide

The great debate between investors begins with active or passive investing. Is one better than the other? Wealth managers and investors may seem to think so, but it boils down to preference and goals.
Active and passive investing are complete opposites, contrasting each other in many ways. For example, would you prefer to exceed the benchmark set while investing short-term or settle with average performance over a length of time?
Let’s break down each of the investment strategies for you here. This way, you decide which will benefit your portfolio the most.

What Is Active Investing?

To be active, one is engaged or pursuing a task. There is no time for sleep when investors are actively investing, you don’t want to miss a favorable fluctuation.
This strategy requires a portfolio manager. The manager is in charge of the account, monitoring the activity closely and making investment decisions on your behalf.
Their goal is to get you, the investor, the highest rate of return, beating out the fluctuations found in the stock market. It’s all about market timing for the active managers, as they attempt to buy low and sell high.
It’s easy to believe that only one person is working on your account too. Don’t be fooled. There is an investment team working under the manager, a team of analysts that are paying attention to both qualitative and quantitative factors.
Qualitative factors are not charted on a map like quantitative data is, which makes the process of extracting it more difficult but just as important. These factors give analysts an idea of how a company is behaving and what competitive advantages they have in the market.
Quantitative factors, on the other hand, are obtained through formulas. Using public data such as financial statements, experts can measure the performance of a company in numeric form before making buy or sell decisions.

How Active Investing Works

Ready to get hands-on and actively invest? If so, here are some steps to incorporate into your strategy:
  1. Determine the investment goals and the accepted level of risk. Before you can actively invest, you need a plan in place that includes your expectations, your liquidity needs, and more.
  2. Prepare the investment policy statement or IPS. This document buttons down your investment strategy, including the reporting requirements, manager fees, and other general rules the portfolio manager is required to follow.
  3. Introduce the active managers. It’s their responsibility to build forecasts on risk and return and prepare the asset allocation.
  4. Do not neglect the portfolio, monitor it frequently. Revisions are common to keep the portfolio balanced to achieve the specified benchmark and objectives set in the plan.

Benefits of Active Investing

Are you a day trader, or a short-term investor willing to assume a high level of risk in investing in the market? If so, active investing is a match for you.
Let’s look at some of the benefits of active investing:
  • The mentality of an active investor is that the market can be beaten or outperformed. If the strategy is successful, the returns are favorable.
  • Asset allocation is more tailored to investment goals, as they are re-balanced often to maintain alignment.
  • There is some risk mitigation in the event the market crashes, to some extent. This is parallel to the re-allocation of assets as active managers, in theory, can predict when downturns may happen to act accordingly.

Disadvantages of Active Investing

Time for the disadvantages of active investing. This includes:
  • A high volume of buy and sell transactions greatly increases the overall fees
  • The decline in performance, dependent on the skill of the portfolio manager
Do the advantages outweigh the disadvantages of active investing? We will let you decide.

What Is Passive Investing?

When someone acts passively, they are accepting. There is little to no response given nor required. Many investors prefer this strategy as they hand off their investment contribution and move on to other everyday tasks.
One way to describe passive investing is through the long-term buy-and-hold approach. Investors aren’t as concerned with setting a benchmark but are comfortable tracking and matching returns from a comparable index fund, such as the S&P 500.
Passive investing may be referred to as “boring success.” This is primarily due to the slow growth it churns over time, versus active investing where results may be instantaneous if the cards are dealt right.

History of Passive Investing

John Bogle, the founder of Vanguard (a mutual fund company), introduced the world’s first passive investment fund during the 1970s known as the Vanguard 500 Index (VFINX).
Investors saw this fund as affordable. It was priced less than many other mutual funds on the market while including top-name companies in the portfolio.
As other companies joined in on the bandwagon, the 1990s changed the face of passive investing with the introduction of exchange-traded funds (ETFs).

How Passive Investing Works

Ready to build potential wealth through passive investing? Here’s how to get started:
  • Open an investment account. Compare the brokerage fees and minimum deposit requirements, as there is a selection of firms to choose from.
  • Decide on funds. Which one appeals to you and aligns with your investment goals? If you aren’t sure, seek advice from a financial advisor or check the charts. How is the fund performing and what does it have to offer?
  • Determine your risk appetite.
  • Make recurring contributions to build your portfolio. Staying consistent is the key to success with passive investing. Automatic contributions can be set up, otherwise, discipline yourself and commit to a frequency (monthly, quarterly, or annually).

Benefits of Passive Investing

Passive investing is growing in popularity amongst the investment community, here is why:
  • The fee structure is lower than that of active investing. For one, investments are not turning over as quickly. Instead, they stand firm. Passive investing does not require people to manage them either, reducing management fee costs and more.
  • The asset composition of an investment portfolio is not hidden. Investors are kept in the know.
  • There is tax efficiency. Because passive investing holds the buy-and-sell active tradition, investors do not need to worry about paying taxes on large capital gains incurred.

Disadvantages of Passive Investing

If passive investing costs less, what disadvantage can it possibly have? The answer is protection.
There is no one behind the scenes actively managing the account. The index selected is being mirrored. If a market crash occurs, the portfolio is going to decline.
Another disadvantage piggybacks off of the benchmark index. It contains a pre-set asset mix. This means, if one segment shows poor performance, it is not replaced in the portfolio. The benchmark index would need to be modified to offset it.

What Types of Investments Are Actively Managed Versus Passively Managed?

Let’s begin with actively managed accounts.
Mutual funds tend to fall into this category, although there are a select few which can be passively managed. They are professionally managed accounts using pools of money obtained from investors to purchase securities.
Passively managed investment accounts primarily include exchange-traded funds and other index funds.
The simplest way to determine if an account is passive or active is by checking if it tracks the return of an index. If it does, it’s passive. If it doesn't it’s active.

More About Mutual Funds

Investors purchase mutual funds because they:
  • Are actively managed
  • Are diversified portfolios
  • Have a low initial investment, making it more attractive and affordable
  • Are liquid. If money is needed, shares can be redeemed quickly.
Mutual funds also come in different shapes and sizes. You can choose from:
  • Money market funds - issued by U.S. corporations, and the federal, state, and local governments. Money market funds carry the lowest level of risk.
  • Stock funds - There is a list of stock funds including index funds, sector funds, growth funds, and more. Some may pay out regular dividends, whereas others are tailored towards attaining gains.
  • Bond funds - These hold the highest level of risk, but also can produce high returns on investment.
  • Target date funds - also known as lifecycle funds. You may be familiar with these funds as they are used with 401(k)s, designed to achieve an investment goal based on the anticipated age of the individual at retirement.
Adopt the one that best fits your objectives, selecting from different levels of risk, features, and overall rewards.

More About ETFs

Whether you are just starting in investing, or you are an experienced professional, ETFs make diversification effortless.
Just like mutual funds, ETFs are also available in different types. A few to name include:
  • Equity ETFs
  • Bond or Fixed Income ETFs
  • Commodity ETFs
There are many more types available on the market for investors to choose from too.

The Bottom Line

As with all major decisions in life, weigh out the pros and cons of active and passive investing before settling on a choice. And if you can’t choose between the two strategies, blend them!
There is no right or wrong, as long as the strategy you select aligns with your investment goals and your risk appetite.
Visit LifeGoal Investments to learn more about the benefits of long-term growth through exchange-traded funds. LifeGoal Investments offers ETFs actively traded on the stock market to build wealth, save for a home or education, and more.
Carefully consider the Fund’s investment objective, risks, charges, and expenses before investing. This and other additional information may be found in the statutory and summary prospectus, which may be obtained by calling 1-888-920-7275, or by reading the prospectus. Read the prospectus carefully before investing.
 
Distributed by Foreside Fund Services, LLC. Member FINRA.
 
ETFs are only one option when seeking to achieve goals. Prior to investing in any of the LifeGoal ETFs you should consult with your financial advisor to determine whether the specific funds are appropriate for you and, if so, how your investment plan should be implemented. The LifeGoal ETFs are not intended to be short term savings vehicles for payment of monthly expenses.
 
IMPORTANT RISK INFORMATION:
 
Investing involves risk, including loss of principal, and there is no guarantee that that Fund will meet its investment objectives. The value of a fund’s shares, when redeemed, may be worth more or less than their original cost. The Fund bears all risks of investment strategies employed by the underlying funds, including the risk that the underlying funds will not meet their investment objectives. ETFs may trade in the secondary market at prices below the value of their underlying portfolios and may not be liquid. Fixed income investments are affected by a number of risks, including fluctuation in interest rates, credit risk, and prepayment risk. In general, as prevailing interest rates rise, fixed income prices will fall. Lower-quality bonds present greater risk, including an increased risk of default. An economic downtown or period of rising interest rates could adversely affect the market for these bonds and reduce the Fund’s ability to sell its bonds. The lack of a liquid market for these bonds could decrease the Fund’s share price. Investments in international markets present special risks including currency fluctuation, the potential for diplomatic and political instability, regulatory and liquidity risks, foreign taxation, and differences in auditing and other financial standards. Exposure to the commodities market may subject the Fund to greater volatility than investments in traditional securities. The Fund is a new ETF with a limited history of operations for investors to evaluate.
 
Investments made through an ETF and the results that those investments generate are not expected to be the same as those made through any other ETF from LifeGoal Investments, including one with a similar name. Additionally, a new or developing ETF’s performance may not be representative of how that ETF will perform in the future. Newer ETFs that are still developing may not yet have the assets to reach efficient investing and trading status. Furthermore, certain factors may affect the performance of a smaller or developing ETF in its early stages. An ETF may need to sell portions of its portfolio at certain points due to unpredictable purchasing patterns. However, the changes in an ETF’s overall value as the result of an unexpected portfolio change are not expected to be representative of the ETF’s long-term performance.